STRENGTHS

Strategic location at the centre of trade routes between Asia and the Middle East

Indian, Chinese and Japanese interests

Strong growth of tourism

WEAKNESSES

Agricultural production vulnerable to climate disasters

Low levels of capital public spending due to debt servicing burden

Reliant on short-term external financing

Lack of infrastructure

RISK ASSESSMENT

Stronger growth in 2018

After a particularly weak 2017, growth is expected to be more dynamic in 2018. A recovery is likely in the agricultural sector, which was heavily affected by the droughts and floods that hit the country in the first half of 2017. These episodes weighed on household consumption during the year, as the shortage caused a temporary rise in inflation. This inflation is expected to slow down in 2018 against the backdrop of tighter monetary policy by the central bank, which cut its main interest in April 2018 in response to the gradual rise in the US Federal Reserve System’s key interest rates and 2017’s weak economic results. Tourism should also benefit from better weather conditions.

Industrial activity growth is set to be strong, stimulated by the reinstatement of the generalised system of preferences with the European Union since May 2017. The removal of tariffs for nearly 1,200 Sri Lankan products (including tea and other agricultural products, as well as various textile products) should greatly benefit the manufacturing sector, for which the EU is the largest export market. However, uncertainties about Brexit conditions and its implications for UK growth are expected to affect the sector, as the United Kingdom accounts for 30% of Sri Lanka's exports to the EU. Meanwhile, the construction sector will likely be boosted by government support for infrastructure projects and the positive impact of Chinese company CMPort’s takeover of the Hambantoa port in July 2017. This major investment project – combined with the government-led fiscal consolidation reforms under the auspices of the IMF and the relatively stable political climate – should reassure foreign investors, and stimulate investment.

Public finances still fragile despite gradual improvement

Engaged in a process of fiscal consolidation with support from the IMF, the Sri Lankan government is continuing its efforts to reduce the deficit and debt, despite the constraints caused by 2017 climatic disasters. The priority of the reforms is to improve tax collection. Foreign investments, such as those related to the Hambatoa port, make it possible to generate revenues that are then used to reduce debt. Nevertheless, the large share of some hard-to-reduce fixed costs, such as the salaries of civil servants (representing 25% of government expenditure), will prevent the government from reversing this trend in the immediate future. The government should, however, be able to meet its debt payment deadlines, thanks to the fifth disbursement of the IMF’s Extended Fund Facility (EFF) in June 2018, as well as the sovereign bond issuances conducted at the start of 2018, which allowed for a greater access to international markets. Foreign reserves, equal to USD 9.9 billion in May 2018, should approach but stay below the IMF’s target that is required to cover foreign exchange claims falling due in 2018.

In terms of external accounts, the current account balance is expected to remain in deficit in 2018, with remittances from expatriate workers and tourism revenue only partially offsetting the trade balance deficit. The latter should widen, as the rise in exports remains lower than the increase in imports driven by higher oil prices. In addition, despite expected growth, FDI will likely remain low compared to neighbouring countries. As a result, the rupee is likely to remain under pressure.

Persisting destabilizing factors

While the country’s political stability seemed assured after the 2015 elections, political tensions within the governing coalition formed by President Maithripala Srisena (Freedom Party) and his prime minister, Ranil Wickremesinghe (United National Party), have been mounting since the coalition’s setback in the February 2018 local elections. Capitalising on his victory, the leader of the main opposition party Mahinda Rajapaksa (Sri Lanka Popular Front) introduced a no-confidence vote against the government in Parliament. Although rejected, the motion led to the defection of 16 deputies within the presidential party, some of whom were members of the government. As a result, the governmental coalition lost the absolute majority in Congress. On the back of such internal divisions, the vote of the constitutional reform project launched in March 2016 is unlikely.

Furthermore, tensions remain between the Buddhist majority and the Muslim minority (9% of the population). Violent inter-ethnic clashes across the country in March 2018 led to the temporary implementation of a state of emergency. In addition, Sri Lanka faces international pressure from the United Nations Council, pending the government's recognition of human rights violations, and the adoption of recommendations to sustain reconciliation between the Tamils and Sinhalese.

Improving the business environment is one of the government's priorities, but accusations of favouritism and corruption are sometimes directed against leaders.